The pressure on banks to merge is rising.

Photograph: PHILIPPE HUGUEN/AFP/Getty Images

Markets Give Europe's Bank Tests a Failing Grade

Mark Gilbert is a Bloomberg View columnist and writes editorials on economics, finance and politics. He was London bureau chief for Bloomberg News and is the author of “Complicit: How Greed and Collusion Made the Credit Crisis Unstoppable.”
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In the wake of the financial crisis almost a decade ago, regulators in various jurisdictions decided it would be a good idea to stress test their banks. By seeing how financial institutions would cope with a crisis, investors would be reassured about the system's resilience. So the 7.6 percent drop in the value of European banks in the first two trading days following Friday's late-night release of the region's latest assessment should be cause for concern.

QuickTake Stress Tests

Bank stocks have been underperforming their non-financial peers all year. The benchmark Stoxx Europe 600 index is down less than 10 percent since the start of the year; the banking component has lost more than three times as much value, and is worth about half of what it was a year ago:

Only two of the 51 lenders appraised by the European Banking Association saw their common equity tier 1 ratios -- a measure of capital as a percentage of risk-weighted assets -- fall below the 4.5 percent minimum regulatory requirement in the tests. Allied Irish Bank's ratio dropped to 4.3 percent in the adverse scenario; only one of the 51  tested, Italy's Banca Monte dei Paschi, saw its capital wiped out. And yet investors interpreted the test results as a reason to continue doing what they've been doing consistently for the past year -- selling bank stocks:

On Wednesday, Moody's Investors Service cut its outlook for the Spanish banking system to stable from positive. "The low interest-rate environment, which has so far supported economic growth and reduced the financial burden of the highly indebted private sector, is becoming more burdensome for lenders by pressurizing net interest income," the rating company said.

With the European Central Bank still more likely to ease monetary policy further than tighten it, and the Bank of England poised to reduce borrowing costs on Thursday as its response to the Brexit-inspired weakening of the economic outlook, there's scant prospect of banks getting any relief on the interest-rate front.

A different solution is needed for Europe's financial sector: Instead of watching the banks become too small to function properly, there needs to be fewer banks. Italy has 64 bank branches per 100,000 people, while Spain has 70, according to the World Bank; that's double the ratio in the U.S. or Japan. Consolidation will also enable Europe's banks to clean up their balance sheets. While the burden of non-performing loans in Italy gets the most attention, in the euro area as a whole they are 5.7 percent of gross loans, compared with 1.4 percent in the U.K. and 1.5 percent in the U.S. Easing that drag on the banking system and eliminating the surplus of bank branches will, of course, will be painful, not least politically.

In April, UBS Chairman Axel Weber said the pressure for large banks to reduce their balance sheets makes it almost impossible for them to consider takeovers, so the necessary "creative destruction in the banking sector just doesn't happen." But Intesa Sanpaolo Chief Executive Officer Carlo Messina said in a Bloomberg TV interview on Wednesday that while cross-border takeovers and mergers are unlikely because of the cost-cutting that would be needed, combinations within countries are likely:

To work on synergies between European banks you have to talk about the possibility to reduce costs between different banks that are in different countries. Consolidation between European banks can happen only in lines of business, but not between big players. In my view there are too many banks. There could be consolidation within countries, and within countries you can exploit synergies. We will see a lot of consolidation within countries.

Fewer, stronger national banks would go some way to building a more efficient finance industry. Regulators should be actively seeking ways to encourage mergers  between stronger firms and their smaller competitors. It will be up to the politicians to sell the need for consolidation and cushion the blow. If they fail, the central bank efforts to revive the European economy by pumping in money will continue to be undermined.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

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Therese Raphael at